Compensation Philosophy: Lead, Lag, or Match Strategy

Introduction to Compensation Philosophy

Compensation philosophy refers to the approach a company takes to determining employee compensation. Total compensation is a mix of pay and benefits, as well as the structure that pay takes. The compensation philosophy should be aligned with the company's overall strategy. For example, Walmart pays at relatively low rates in order to compete on a low-cost basis — a lower cost of doing business supports that approach. Costco takes a different approach, believing that paying above market rates for its employees will deliver higher workplace engagement and a more experienced, efficient workforce. The thinking is that gains in efficiency and engagement will offset the higher cost per worker. Thus, two firms in the same industry can hold different compensation philosophies, but each philosophy must be aligned with the rest of the business, including its key strategic objectives.

The Three Compensation Philosophies

There are three basic compensation philosophies: lead, lag, or match the competition. The foundational philosophy is to match the competition, which means setting compensation policies in line with the market (SHRM.org, 2015). Under this approach, competitors essentially set the bar for compensation across different roles, and a company follows suit. This is also known as a match strategy.

The lead strategy is when the company sets compensation ahead of the market, with other companies following. As the compensation leader, the firm typically offers higher pay rates than competitors. This approach is often used to attract stronger candidates, and there are frequently sound operational reasons for it. Companies with the best talent are often the best-performing companies, and having access to a superior applicant pool can be a meaningful source of competitive advantage.

The lag strategy involves paying below the market rate for jobs. This can work in two ways. First, a company may compensate for lower pay by offering superior non-monetary benefits — such as a positive work environment, meaningful opportunity, intellectual challenge, or strong upward mobility. This pattern is often seen in technology startups, where cash flow constraints exist but employees are willing to accept lower salaries because the work is intrinsically rewarding or the growth potential is significant. Second, the lag strategy is also used by companies that rely heavily on unskilled labor. Unskilled labor markets tend to feature high turnover and elevated error rates, so companies that must draw on this labor pool often seek to minimize per-worker costs, ensuring that each worker still contributes net value to the organization.

Recommendation: The Lead Strategy

A lead approach to compensation is generally advisable, though it must always be aligned with the firm's strategic objectives and operational model. The core rationale for recommending the lead strategy is straightforward: the most successful companies are those that strive to be the best and to dominate their industries. Settling for anything other than the leading market position is inherently less stable over the long run. To achieve and sustain that leadership, a company needs better, smarter people than its competitors — and to attract those people, it typically needs to offer superior compensation. On average, talented employees prefer higher earnings, all other factors being equal, and top companies also offer meaningful opportunity that compounds this appeal.

Sturman and McCabe (2006) note that the lagging strategy typically does not pay off. It offers poor utility because a company that attracts weaker workers will continually struggle in the marketplace. The best workers within such a company are likely to be recruited away by competitors, resulting in higher turnover intention. Their study showed that total utility is higher for the lead strategy at all compensation levels, and is highest at the 5–10% premium level, beyond which a company may hit the point of diminishing returns — overpaying employees past the threshold at which those individuals can outperform their counterparts at other firms.

The match strategy does not underperform in terms of utility, but it does not position a company to derive competitive advantage either. The lead strategy is the only one from which human resources can generate genuine competitive advantage, because it attracts the best people. Over time, this impact compounds: the company develops a stronger employer brand than its competitors, eventually attracting superior talent on reputation alone, thereby locking in productivity gains without proportional increases in recruitment cost.

Conclusion

The choice of compensation philosophy depends on the specific circumstances of the employer, because compensation philosophy must be aligned with the overall strategy and strategic objectives. A philosophy that is misaligned will create inefficiencies — for example, placing grossly overqualified employees in roles that do not leverage their abilities, or placing underqualified employees in roles that demand more than they can deliver. If McDonald's, for instance, were to hire MBAs to manage its restaurants at six-figure salaries, it could attract those individuals, but their skills would almost certainly be wasted in that operational environment.

In general, a firm should invest most heavily in compensation for the roles and functions from which it extracts its greatest competitive advantage. Where it extracts limited advantage, matching the market is appropriate. The evidence, however, suggests that there is almost never a benefit to lagging the market — even for minimum-wage positions, matching should be the floor. The lead strategy, when properly aligned with business strategy, remains the most powerful compensation philosophy for firms that aspire to sustained competitive advantage.

References

Bowman, Jeremy. "Why Wal-Mart will never pay employees as much as Costco." Motley Fool [Web]. 2016. Retrieved December 5, 2017.

SHRM.org. "Planning and design: Compensation philosophy — What are the advantages or disadvantages of lead, match or lag compensation strategy?" SHRM.org, 2015. Retrieved December 5, 2017.

Sturman, Michael & McCabe, David. "Choosing whether to lead, lag or match the market." Scholarly Commons, 2006. Web. Retrieved December 5, 2017.